Derivative Action Alleging Board's Refusal to Prevent Regulatory Action by the FDA Failed to Overcome Requirement of Demand on Board

Last week the US District Court for the Northern District of Illinois dismissed a derivative action brought in a consolidated suit by various shareholders of healthcare company Baxter International based on the shareholders’ failure to establish demand futility. The shareholders claimed that members of the Baxter board (1) failed to comply with a Federal Drug Administration (FDA) consent decree regarding one of the company’s faulty products, (2) failed to adequately monitor the manufacture of a drug marketed by Baxter, (3) made misrepresentations regarding the company’s profits and revenues and (4) engaged in insider trading. The shareholders argued that demanding the board pursue this litigation would have been futile because the board was not impartial.

A key issue was the standard applicable to the shareholders’ claims of a failure to comply with the consent decree. The parties disagreed with whether Aronson – the more lenient test for futility where an affirmative decision of the board of directors is being challenged – or Rales – a more demanding test where a shareholder alleges an unconsidered failure of the board to act or manage – should apply. The District Court, applying the Seventh Circuit decision Abbott Labs, found the shareholders adequately pled that the board had made a “knowing choice” not to comply with the FDA consent decree. As a result, the Aronson test applied, requiring the shareholders to show either reasonable doubt that the board members were independent or disinterested, or had acted in bad faith.

On all claims, the shareholders failed to meet the high standard of acting in bad faith. In particular, with regard to Baxter’s alleged failure to comply with the FDA consent degree, the District Court found that, even accepting the shareholders’ allegations, the board had acted with good faith in its efforts. Although the FDA ultimately demanded a product recall, the board members could not be liable for business judgments even if their efforts were “deeply flawed” or “fail[ed] spectacularly.” Despite the benefit of the more lenient Aronson test, the shareholders’ inability to plead a defect in the board’s decision process, rather than the outcome, was fatal. Because the shareholders “had ample opportunity to put [their] best foot forward,” having had access to Baxter’s books and records, submitted witness affidavits, and previously amended their complaint, the claims were dismissed with prejudice. North Miami Beach General Employees Retirement Fund v. Parkinson, No. 1:10-cv-06514 (N.D. Ill. Sept. 19, 2012).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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